Don't Fall for This Magical Panacea, Share Buybacks are Dangerous to Your Dividends

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Many investment advisers like to recommend stocks with large buyback programs. A buyback, they argue, is like some sort of magical panacea.

It allows companies to invest in themselves which pushes the share price higher.

On the face of it, the premise seems logical enough. But the reality is that it's not quite that simple.

In fact, you can call me old-fashioned if you like but I believe large buyback programs can actually be dangerous and stocks with them should be avoided. I'll tell you why.

It primarily has to do with the rise of corporate options schemes as form of compensation.

Of course, it wasn't always this way.

Before "options as compensation" became so widespread, management usually owned shares directly just like any other shareholder. It meant they were just as interested in receiving their dividends as the guy on the street.

That has all changed. Now that management has ownership largely in the form of stock options, they're not as keen on dividends. As option holders they don't receive them.

They also recognize dividend payouts cause the share price to fall after they are paid, lessening the value of their all-important options.

It's all about the money you see which is why options-rewarded management came up with share buybacks in the first place.

For options-rewarded management, buybacks have two advantages.

First, they reduce the number of shares outstanding, thus increasing earnings per share and the value of the remaining shares.

Second, if management has a lengthy list of options and wants to exercise them, the share buyback scheme counterbalances the move since the company's earnings per share won't be diluted and its perceived growth rate will stay the same.

It's a sneaky way management uses the shareholders' money in a clever shell game.

The Larger Problem with Share Buyback Schemes

But if that was the only problem, share buybacks would be only moderately damaging.

Certainly, they would still be unattractive to individual shareholders, because most buyback programs are carried out by direct negotiation with large institutions, cutting out small shareholders.

However, the other problem with buybacks is the effect of the business cycle.

Like most economists, corporate management types are usually quite poor at spotting key turning points in the business cycle.

Hence, when business is booming and cash flow is good, management uses the excess cash flow to increase share repurchases. It only follows that they do so at prices near the top of the market.

The problem comes when the market turns. As the downturn inevitably ensues it leaves the company short of cash which means the company has to stop repurchasing shares. This makes buyback schemes pro-cyclical.

The buybacks push up share price even further in good times and are then suspended in bad times, allowing the share price to fall further than it would ordinarily.

Indeed, sometimes the company is actually forced to carry out an emergency share issue at the bottom of the market which effectively robs existing shareholders because the management is forced to buy high and sell low.

You don't need to be a seasoned investor to recognize the problem with this strategy.

The Tug of War Between Buybacks and Dividends

Finally, there is the effect of share buybacks on cash dividends.

For reasons described above, management is much keener on share buybacks than on cash dividends, so they tend to substitute one for the other.

Or, if shareholders insist on a cash dividend, they carry out share buybacks as well, often paying out more than 100% of their earnings.

Either way, the cash dividend is in much more danger with a company that repurchases shares than with one that does not.

Here's why.

When hard times inevitably arise, a company that pays out only 30-50% of its earnings in a cash dividend is generally able to maintain the dividend, but if it has been paying out 80-120% of its earnings in dividends and share buybacks, it is generally forced to suspend both the buybacks and the dividend.

Further, once the dividend has been suspended, it is generally resumed only at a much lower level.

The point is share buybacks only endanger dividends. We saw this at work in the banking industry with the 2008 crash.

For example, before the crash BB&T Corporation (NYSE: BBT), a generally well-run outfit was both paying a quarterly cash dividend of 46 cents/share and buying back stock.

After the market turned down in 2009, BB&T stopped buying back stock, abandoned the dividend, and issued new stock at a much lower price than had existed before the crash.

Now the dividend has been resumed, but at a quarterly rate of 20 cents per share. The blessing is that BBT has now stopped buying back stock and instead plans to raise the dividend.

Other banks, such as JPMorgan Chase (NYSE: JPM) have followed the same pattern, with the dividend being abandoned and then resumed at a much lower rate.

However, in this case JPM has also resumed share buybacks. Don't fall for it.

No matter what you financial advisor may tell you, there is more to share buy backs than meets the eye.

Wow!! Thank you Martin. I read about 2 hours every day, mostly financial stuff, and this is the first time I have ever seen this kind of insight into something that had me, and I am sure, a lot of other investors fooled. As usual, Martin, a great article with great insight.

What if instead of paying out a dividend, the company decides to repurchase its own shares on the open market? Share buybacks increase EPS and share price. And although buybacks are taxed as a capital gain when sold, the choice of when to sell them is up to the shareholder. Let’s say Orange is going to earn $100 million, or $1 per share, this year. Because of its growth rate and future earnings prospects, the stock is trading at a P/E multiple of 100 times earnings, or $100 per share. How many shares of stock could the company buy back with the $1 billion it has in cash?

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